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Greening the Financial System: Tilting the Playing Field

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Greening the Financial System: Tilting the Playing Field Greening the financial system Tilting the playing field The role of central banks OCTOBER 2019 o o 2 o 2 2 2o 2o CO2 $ CO2 CO2 € CO2 ¥£ Prepared by the Climate Bonds Initiative Supported by WWF and Prashant Vaze, Alan Meng, Diletta Giuliani SOAS Centre for Sustainable Finance Summary Climate change, through physical damage to assets owned by banks and insurers and through an abrupt reduction in value of fossil fuel related assets, represents a risk to the stability of financial institutions and the financial system as a whole. Risks of climate change are long- term, rising, poorly understood and hence under-valued by the short- term metrics used by banks to evaluate financial risk. Governments have the primary responsibility for developing policy to reduce climate risks. But Central banks and financial regulators (CBFRs) can and, this paper contends, should play an important role too. CBFRs have established the Network for Greening the Financial System. The Network is being used to share research and experience on how best to manage climate risks. As regulators, lenders of last resort and monetary policy makers, CBFRs have a variety of tools to influence the lending and investment behaviour of banks and insurers. Individual CBFRs are already undertaking actions to raise the awareness of climate risks in financial institutes and apply these principles in their own operations. But they could do even more. They could help establish reporting norms, and then mandate banks and insurers to disclose their climate risks and perform climate stress tests. They could themselves tilt their own purchases of financial assets so as to buy less fossil- fuel intensive assets and more green assets. They could change the weightings applied to the regulated financial assets banks and insurers hold to better reflect long-term climate risks. In several emerging markets, where central banks play an important role in determining the allocation of credit in the economy, CBFRs could develop quotas so that financial institutions switch their lending to and investment in from brown activities to green. Greening the Financial System Climate Bonds Initiative 2 Introduction “4°C warming makes the Box 1: world uninsurable” Summary of recommendations from TCFD and NGFS reports Thomas Buberl, Axa CEO1 Task Force on Climate-related Financial NGFS – comprehensive report – Disclosures – June 2017 April 2019 TCFD made recommendations to G20 Recommendations to CBs: This briefing paper looks at the role central about the disclosures all organisations • Integrate climate-risks into monitoring banks and micro-prudential financial should make to their stakeholders to and supervision activities. regulators (CBFR) could play in greening facilitate the market’s understanding of the financial system. Central banks are climate related risks. • Implement them in portfolio concerned with regulating macro-economic management. • Governance: Board and managements role goals like stable inflation and output growth, in assessing and managing climate risks • Bridge data gaps availability of credit to sectors and the overall stability of the financial system. • Strategy: Where material, disclose • Supply technical assistance and share Micro-prudential regulators are more short, medium and long-term risks and knowledge within the central banking concerned with the stability and conduct of opportunities including resilience to community. individual financial institutions. This paper different climate scenarios For the policy makers and the private lumps together central banks and micro- • Risk management: How organization sector, it calls for: prudential regulators even though in many will manage climate related risks countries responsibilities are spread over • Robust and consistent disclosure of multiple organisations with the precise • Metrics and targets: Disclose the environmental risks, and; demarcation varying between countries. organisations’ direct and indirect • A taxonomy of green and brown assets. emissions and targets Section 1 provides a background of how the CBFR’s have been adopting the climate There were supplemental recommendations change risk agenda. Section 2 of the paper to the finance sector (lender, underwriter, discusses the current roles played by CBFRs investor and asset manager) of the role it and reviews the instruments in current plays in capital allocation and the leverage use (though not necessarily for ‘green’ this provides to lead best practice. purposes). Section 3 covers current policies for reducing climate risk. Section 4 talks about possible actions they could take to have committed to support the TCFD This paper frequently refers to the bond reduce climate risk. recommendations;4 though investors say market and speaks to the use of green bonds. disclosure is still insufficient with only 25% CBFR’s remit covers the entire financial The discourse around central bank action of companies reporting on five or more of system and many of the points being made has advanced markedly over the past few the 11 recommended disclosures. apply equally to other financial instruments, years. Mark Carney’s Tragedy of Horizons especially loans. That said, the bond market speech,2 given to an audience of insurers Fast forward two more years, to April 2019, is critically important: around half of all at Lloyds, marked an important point: a central banks assembled into a coalition- financial assets, roughly USD 100 trillion,7 senior central banker, the then chair of the of-the-willing, the Network for Greening are held as bonds, especially by long-term Financial Stability Board, articulated the the Financial System (NGFS), published its investors like pension funds.8 Bonds issued risks and opportunities stemming from first “comprehensive report”. It outlined six by developed market sovereigns and climate change. He spoke about the “current actions that should to be taken by central high-quality corporates, because of their and prospective financial stability risks banks, governments and industry (see Box low risk of default and liquidity, play an from climate change” and the role financial 1).5 In essence, the report suggests that important role in financial regulation. They policy-makers need to play “in ensuring the CBFRs implement climate-risk thinking are used by banks and insurers to comply financial system is made resilient to any in their own actions, provide technical with supervisors’ requirements to hold transition hastened by those decisions, and assistance to financial institutions (FIs) and High-Quality Liquid Assets to fulfil Basel that it can finance the transition efficiently.” recommend that FIs collect and disclose III’s pillar 1 requirements. This has created a His message was clear: climate change was more data to the market. Box 1 summarises situation where there is a ready market for a risk to the financial system and financial the main recommendations by the NGFS highly rated sovereign bonds even if they pay policy makers needed to act. and the TCFD. negative interest rates.9 In 2016, the influential Taskforce on Climate The securities and exchanges As prudential supervisors and monetary Related Financial Disclosures (TCFD)3 was regulators (IOSCO) have also established authorities, CBFRs have a huge impact on established by the Financial Stability Board a sustainable finance network. This the bond market, including by (a) deciding (FSB) and chaired by Michael Bloomberg. has already published a short explanatory whether or not particular bonds may serve Its 2017 report has played a significant paper.6 The network is kicking off work as collateral, (b) determining and validating role in steering the direction of the current by undertaking a stock take on current any adjustments made to allow for their debate on transparency. The most recent actions by members especially riskiness, and (c) proscribing which sorts of status report says that 785 organisations, on standards for ESG disclosures bonds to purchase for own-account reasons. of which 374 are in the financial sector, recommended by regulators. Greening the Financial System Climate Bonds Initiative 3 What do CBFRs do and what should they do? they can use and will effect the range of of QE first in Japan then US and Europe in “With great power comes existing skills and competencies. Their response to deflationary pressures. great responsibility.” roles in overseeing conduct, supervising, Increasingly central banks speak about investigating and remedying infractions and Uncle Ben climate change as a threat to financial complaints will occupy much of staff time, (Spiderman’s uncle) systems, framing their initiatives as a and determine the skill sets of the staff. response to the market’s under-pricing of Box 2 gives a summary of CBFR’s roles climate risk. In an open letter three central CBFRs roles include the following: and instruments. The underlined items are bankers comment:12 “…We recognise that discussed further as possible instruments to the challenges we face are unprecedented, 1. limiting inflation through setting green financial systems. urgent and analytically difficult. As long as interest rates and reserve requirements, temperatures and sea levels continue to influencing the supply of money and This means that within their current legal rise and with them climate-related financial the allocation of credit in the economy frameworks central banks’ focus is on risks, central banks, supervisors and financial (monetary policy) economic goals such as price stability, institutions
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